Why Fund Managers’ Hot Performance Isn’t So Hot

Where have all the geniuses been hiding, and why have they suddenly been popping up everywhere?

When the first quarter’s performance numbers come out next week, they will likely look impressive — again. In 2009, 95% of intermediate bond funds beat the Barclays Capital U.S. Aggregate bond index, according to Lipper Inc. And 68% of diversified U.S. stock funds beat the Standard & Poor’s 500-stock index. Year to date, 58% of stock and bond funds alike are earning fatter returns than their benchmarks.

So does the average fund manager — long derided as the functional equivalent of a blindfolded chimpanzee — deserve an apology and a round of applause?

In a word, no.

Consider the Barclays Aggregate, the market average against which many taxable investment-grade bond funds compare themselves. It gained 6% in 2009. The average intermediate bond fund, meanwhile, was up 14%.

Why? Two-thirds of the Barclays index consists of bonds issued by the U.S. Treasury and government-related entities. Corporate bonds are only 18% of the benchmark.

According toMorningstarInc.,the average intermediate-term bond fund looks very different — with about half its assets in government bonds, nearly 40% in corporates and almost 10% in foreign debt.

Why do funds deviate from the index? Funds charge expenses; market averages don’t. A fund with 1% in annual costs has to beat the index by one percentage point to justify its fee. That prods managers toward riskier bonds: longer in maturity, lower in credit quality than Treasurys, or both.

Bond managers also have gotten a boost from Uncle Sam. Now that the U.S. has issued roughly $2 trillion in new debt to bail out the financial system — including $118 billion last week — government bonds make up even more of the index. At year-end 2007, Treasury securities were 22% of the Aggregate index; today, they are more than 29%.

That has shackled the index. Ten-year Treasury bonds lost 9% in 2009 — while intermediate corporate bonds gained 16% and below-investment-grade, or “junk,” bonds returned more than 57%.

Deviating from Treasurys by design, the average bond fund beat the index in 2009 — and continues to do so this year. Thus, “it should be getting easier for active bond managers to beat the market,” says Gregory Seals, fixed-income director at the CFA Institute in Charlottesville, Va.

But the recent hot streak among bond funds is merely the inverse of 2008, when Treasury bonds excelled and everything else smelled. Intermediate Treasurys gained 18%, while high-quality corporate bonds broke even and junk bonds fell 30%. That year, 87% of all taxable-bond funds lagged the Barclays Aggregate index.

It is a similar story with stocks. Ever since mutual funds began in 1924, they have always favored stocks that are smaller than the market average. Managers tend to own roughly 100 stocks — versus the 500 in the S&P index — and to have more concentration in the smallest among them. Therefore, managers outperform the S&P 500 whenever small stocks do better than large.

Take 2009: The stocks that had fallen the most in the crash fared best in the recovery. Small stocks lost 26% in the fourth quarter of 2008 and 15% in the first quarter of 2009, before soaring 27% for the year. So the apparent brilliance of many managers is merely the flip side of their earlier inadequacy. In 2008, only 37% of diversified U.S. stock funds beat the S&P 500, even as the index lost more than a third of its value.

What about the longer term? As of last week, 60% of diversified U.S. stock funds had beaten the S&P 500 cumulatively over the past 10 years — a striking reversal of the historical record, since roughly two-thirds of funds have trailed the index in the long run. But if you measure the funds against an index that includes small stocks, the rate of outperformance drops to 55%. Count the track records of the hundreds of funds that went bust and the winning proportion falls below half.

So the world hasn’t been turned upside-down. Fund managers haven’t become a flock of Einsteins, and low-cost index funds remain the best choice for most investors.